July 29, 2019
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By William Davies
World equity indices plunged during Q4 last year before staging a powerful recovery, regaining virtually all the ground they had lost. This extraordinary turn of events may look irrational, but it tells a coherent story about the fragility of investor confidence as we navigate the end of this economic cycle and approach the US elections in 2020.
In the space of just six months – from last October to the end of March – something remarkable happened in world markets. Having reached their highs on 21 September 2018, the autumn equinox, it seemed as if the seasons suddenly changed and winter came. As Q4 got under way, a steep sell-off quickly took hold during which major equity markets tumbled around 17%, eventually bottoming out on Christmas Eve in the US (Christmas Day in Asia). Then, having shed all their gains for 2018 and more, they broke free of fear’s icy embrace: between late December and the spring equinox on 21 March, world markets reversed course, gaining 18%. Spring had arrived.1
Why did markets take sudden fright like this? And if their apparent fears for the global economy were justified, how can the sudden resurgence of risk appetite be explained? Was the plunge in Q4 an aberration? Or does the subsequent rebound signal dangerous complacency about the dangers facing investors for the remainder of this year and next?
My answer to the last two questions is “no”. The severity of the sell-off during Q4 may have been unexpected but it is explicable, given the background and some of the data that was being released. I also believe the rebound at the beginning of this year is justifiable, even if I have been surprised by the degree of its strength. Both the sell-off and rebound were reactions to a range of rapidly shifting geopolitical risks – especially tensions over Sino-US trade – that investors find increasingly difficult to predict and price in. With confidence brittle and events at times moving quickly, markets may have oscillated more violently than usual, but their reactions were not irrational.
Long-term context is critical here. The current global expansion and corresponding equity market upswing are mature by historical standards – concern is naturally growing that the world must be nearing the downturn that will signal the end of this cycle. It is hardly surprising that investors are on high alert for signs of recession: they have seen nominal economic growth of 3%-4% a year in the US and 4%-5% globally for much of the decade since the S&P500 hit its lows in March 2009, coupled with very modest inflation. Their concerns were doubtless heightened after the pace of growth picked up further in 2017 and last year.
However, this long-running expansion has included several mini-cycles, during which leading indicators such as the Purchasing Managers’ Indices have swung from very strong readings in the 60s, down to the mid-50s in the western world. Each time markets have entered the down leg of one of these mini-cycles, investors have feared it signals a full-blown recession. That pattern repeated itself once again towards the end of last year.
STRONG LEADERS AND TRADE TENSIONS
Two major factors prompted the big sell-off during the final three months of last year. The first was the changing political landscape. Over the past few years, a group of nationalist strongmen has taken charge in major economies around the world and adopted a more assertive approach to international relations. The US Republicans may have lost control of Congress, but President Trump remains a domineering and unpredictable figure. In China, Xi Jinping has consolidated his control over the government and removed time limits to his premiership. Elsewhere, Narendra Modi in India, Recep Tayyip Erdogan in Turkey, Jair Bolsonaro in Brazil, Shinzo Abe in Japan and Crown Prince Mohammad Bin Salman in Saudi Arabia are all more muscular, nationalistic leaders than their predecessors, while maverick figures such as Vladimir Putin and Kim Jong Un enjoy significant international influence.
The world has therefore entered a phase in which a strong-willed US president is prepared to argue forcefully that his country’s relations with the world should be reset, but must pursue his claims against a group of increasingly assertive and populist leaders in other countries. This is not a recipe for calm and stability in world markets.
When we consider this potential threat to stability alongside the second major issue that dominated the closing months of 2019 – the deteriorating trade relationship between the two largest economies in the world, the US and China – it is easy to see why markets grew fearful that a sharp slowdown was on the cards. Major disruption to world trade flows and a slowdown in the decades-long process of globalisation would inevitably reduce economic activity, corporate profitability and investment – hence the sharp and synchronised downturn in world equity markets.
This is where the Brexit situation in the UK becomes particularly relevant. As an open, internationally connected economy, the UK is deeply embedded in many of the cross-border supply chains along which trade flows. But if geopolitical changes mean we can no longer be sure those supply chains will continue to operate as they have in the past, it becomes unclear where companies should invest. Many therefore postpone decisions or cancel future capital spending, and this inevitably dents growth. Against this background, it is quite possible for the threat of trade tariffs to turn a softening of growth into a sharp slowdown.
This is where markets stood at the end of November.
AT LAST, SOME GOOD NEWS
At that point, the first major positive sign emerged: the US put on hold its threatened move from 10% tariffs on $200 billion of Chinese imports to 25%. This 90-day postponement lifted the immediate threat of further trade disruption until the end of February, alleviating a major source of anxiety for world markets.
But equity indices continued to fall, their losses accelerating as Christmas approached. Rather than being due to concerns over trade, the sell-off was now being driven by weak economic data, particularly in Europe, where exporters including Daimler and BMW were among the first to warn of hits to their earnings from rising tariffs. There were similar signals from Japan, for example among robotics companies exporting to China, which saw some dramatic falls in orders. At the same time, the flattening yield curve in the US treasury market – often seen as a leading indicator of economic downturns – suggested difficult times ahead.
With concerns growing about the economic data that was coming through, the markets received their second major positive signal: having talked of further rate increases as recently as the final quarter of 2018, the US Fed responded to the weaker outlook and indicated that it no longer expected to raise rates during 2019. This change of stance, combined with the postponement of a further trade confrontation, helped power the rebound in equity indices that ran through Q1.
So the remarkable journey the markets have been on – down almost 20% in a quarter, then up almost 20% the following quarter – can be explained by the economic and geopolitical background. What some interpreted as the early signs of a major downturn did not develop and spread as they had feared, and the events of Q4 last year now look more like another mid-cycle slowdown followed by a rebound. Given the potential for instability which more assertive national leaders bring with them, I believe there should now be a higher risk premium in markets generally. Therefore, I find the strength of the upswing in world markets surprising, but I agree that markets should be higher than they were at Christmas because the outlook is not as dire as had been feared.
US ELECTION COMES INTO FOCUS
Looking ahead, one issue dominates the medium-term outlook: the US elections in 2020 and President Trump’s focus on ensuring a strong economic backdrop for his re-election campaign in 2020. With an election to win, the president will do all he can to avoid a slowdown in the US exacerbated by trade tensions and weak corporate investment. Having lost control of Congress and with a large budget deficit, he will struggle to push through further economic stimulus. But he has a much freer hand in the trade negotiations with China and this is where I expect him to turn to a domestic economic boost. Signs that a deal is on the cards increased significantly in early March, when the US postponed its planned tariff increase indefinitely.
If President Trump can ultimately agree a trade deal with Beijing, particularly one which involves the Chinese buying more goods and agricultural products from the electorally critical central states of the US, this could provide the sort of boost he is seeking for the domestic economy and his prospects of re-election.
Much therefore depends on how the trade talks with Beijing unfold. It is unlikely the US will ultimately impose further punitive tariffs on Chinese imports, although the talks could well hit rocky periods during which a breakdown seems imminent, if only because President Trump needs his opponents to believe he is not about to cave in. This is why his sudden termination of the summit with Kim Jong Un in Vietnam was significant: it sent a message to others who must negotiate with the US about the president’s willingness to walk away if he does not like the deal on offer.
President Trump has already enacted a large fiscal stimulus at the end of 2017 with personal and corporate tax cuts that spurred growth through last year, although the effects of this should begin to drop out of the economic data as 2019 progresses. However, the re-election imperative means that even though the US economy should, in theory, be near the end of the current cycle, a slowdown over the next couple of years is not the most likely outcome. Instead, the recent gentle downturn in growth is more likely to be followed by a buoyant US economy through to the US elections in late 2020. A deeper downturn is arguably more likely after the US election.
VALUATIONS HAVE ROOM TO RISE
On this reading of events, it makes sense for world markets to have rallied from their lows at the end of 2018, albeit the rebound has been stronger than I expected. But even so, on current valuations major equity markets do not look expensive.
The US market trades on about 16 times forecast earnings for 2020. Even if those earnings forecasts are not hit and the true multiple is higher, the valuation still looks reasonable, especially with a 10-year US treasury yield of around 2.5% – down from 3.25% in the summer of 2018 – providing support for risk assets through looser monetary conditions. Expectations for the Fed Funds rate are flat for this year and some even expect a rate cut in 2020, although that seems unlikely to me if my views on the US’s economic performance pre-election prove correct.
European equities are even cheaper, on about 13 times earnings, and the story is very similar when you look at Asia or emerging markets. Most markets do not look expensive based on current earnings forecasts, although given the world economy is getting towards the end of this cycle, we should expect equity markets to be getting gradually cheaper because when the cycle does eventually peak, earnings can be expected to move downwards.
THE CYCLE ROLLS ON – FOR NOW
All this suggests that while the rapid decline and rebound in world markets over the past six months or so was justifiable on the basis of the geopolitical backdrop and a spell of softer economic data, the current economic cycle has further to run. A mini-cycle did not turn into a major downturn… this time.
However, alarm bells are ringing. This is primarily due to the current fragility of the relationships between the world’s large economic blocs and the unpredictability of negotiations between powerful, nationalistic world leaders. Although it is clearly in everyone’s interest to reach a deal, there is no guarantee it will happen and there is plenty of potential for breakdowns and bumps in the road. In view of all this, it makes sense for there to be a bigger equity risk premium in world markets than we have had in the past.
The highly unusual events of the past six months demonstrate how fragile confidence in the economic outlook has become – and how quickly markets can drop 20% or indeed rebound. The worst outcome did not happen, and my central case is that growth will continue until late 2020 and earnings will increase further before we reach the end of this cycle.
When that moment arrives there is no way of knowing whether we will enter a major downturn or simply a relatively short period of slower growth before the economy picks up. But the biggest question for investors everywhere will in any case be the same: when the next downturn does eventually take hold, how much room for manoeuvre will central banks and governments have to protect and stimulate their economies?